In the new year, we see new risks on the horizon for both equity and fixed income investors. Equity markets are anticipating a loss of momentum for corporate profit growth. And, for the first time in 12 years, fixed income investors are forced to wrestle with the challenge of navigating a multi-year upward trend in interest rates at both the short and long end of the bond universe. There are various exchange-traded fund strategies that we believe can help with both challenges.
Equities: Loss of profit momentum could support Low Volatility and Quality
Factors are measurable characteristics of a security that help explain its performance. Academic research has shown that different equity factors have the potential to outperform the broad market, but they have historically done so during different types of market conditions. So what trends do we believe could impact factor performance in 2019?
In 2019, corporate profit growth will face the headwind of difficult year-over-year comparisons to 2018, as we expect the impact of the Trump tax cut to dissipate, monetary tightening to continue, the inventory cycle to turn less constructive for output, and the lagged effect of dollar strength to eat into profitability. Additionally, the deterioration of housing affordability during 2018 is a harbinger of cyclical weakness, in our view, and rising labor costs and buoyant diesel prices due to fuel regulations have worked to squeeze profit margins. A wildcard for profitability will be Chinese-US trade tensions and tariffs.
We expect that a loss of profit momentum in 2019 could lead to increased volatility and correlations. In addition, we expect that the Federal Reserve’s rate increases over the past few years could also exacerbate volatility (historically, changes to the federal funds rate have preceded equity volatility by about two years). Given this view, we believe that the Low Volatility and Quality factors may perform relatively well in such an environment. Additionally, as we move later into the cycle, we would expect the spread between growth and value to narrow, and we believe a factor combination of Value/Momentum may shine under those conditions.